Code Red In High Yield

In my 20 years of managing high yield bond investments, I’ve never seen so many signals that scream caution. Desperate to find yield, investors have poured billions into high yield bond funds and ETFs driving the yield on the
Barclays High Yield Bond Index to just 5.54% -- the lowest level in history. Investors are positioning in a risk they may not fully understand.

Let’s look at what will lead to the next default wave and discuss a tactical strategy that may help you further participate in price gains and also protect your wealth during periods of significant price loss.

While 5.54% looks better than a 10-year Treasury at 2.46%, what is happening beneath the surface is concerning. A greater number of less credit worthy companies are finding funding and at terms unfavorable to investors. A default cycle is ahead.

Bonds are bonds, the thinking goes. Investors need fixed income exposure, so why not get paid some interest? However, high yield bonds are also known as junk bonds for a reason. With the flood of new money into high yield funds and ETFs, that money must get put to work. As buyers rush in, they bid prices up and the interest rates (yields) correspondingly go down. All of this has happened before.

The high yield bond market has come a long way since the financial crisis. Over the last four years, the
Bank of America Merrill Lynch Global High Yield Index has risen to more than $2 trillion in value, doubling from $1 trillion in 2009. To put this into some perspective, it took decades for the high yield market to reach its first $1 trillion in market value.

With so much capital looking to be put to work, lesser quality companies are finding it easy to issue bonds and at terms that are advantageous to them and less favorable to investors. Such marginal companies are more likely to default on their bonds, especially because they are so leveraged. So far in 2014, we have seen $340 billion in new high yield debt issuance which is on pace to top 2013’s record issuance of $477 billion.

Moody’s does something interesting. They rate the overall strength of the bond covenants on newly issued bonds, on a scale of 1 to 5. A higher score equates to weaker covenant quality or terms that are less favorable to the investor. Five is the worst. Recent ratings for the overall market have risen and are now consistently over four. Recall the “no doc” mortgages that featured in the subprime bubble at the top of the last credit crisis. It felt ok then too. We all know what followed.

As an example, the radio broadcaster Clear Channel Communications was able to raise $850 million seeking to raise half that amount. It has debt equal to 12 times its earnings. Worse, the bonds were light on covenants typically in place to protect bondholders. The bonds are rated CCC, which means “currently vulnerable to nonpayment”, “substantial risk” and “extremely speculative”.

Martin Fridson, CFA, in my opinion one of the smartest minds in high yield research, estimates that nearly $1.6 trillion of high yield (“junk”) bonds globally will default between 2016 and 2020.

He believes default rates will surge between 2014 and 2016 and persist through 2020. Bonds don’t lose 100% of their value when they default but a 40% decline, a reasonable guess, on $1.6 trillion is a $640 billion dollar hit on the $2 trillion dollar market. That is a 32% decline in price. Fridson sees a default impact of nearly $752 billion.

So what should you do today? Rather than calling a top in the market (a fouls game in my view), my message today is one of awareness, patience and strategy: Awareness of today’s high level or risk, patience for a coming opportunity and a strategy to tactically position for growth with a plan in place to risk protect your downside.

Let’s first take a look at history through the lens of both risk and opportunity then look at tactical trend-following strategy. Note the yellow circle in the following chart which highlights the current “yield-to-worst” on the Barclays U.S Corporate Bond Index. It is lower than it was at the last two major market peaks (2000 and 2007) and any period prior. Also note the orange highlight which shows the decline in high yield bond prices during the last credit crisis. High yield bond prices dropped over 45% (orange box) causing the yield-to-worst to race higher to over 22%. Importantly, see the opportunity that existed for the investor who didn’t ride the price decline down. Note only were yields over 20% but note just how much prices recovered. The goal is to capture both.

So today, rates are low, money is easy, covenants are light and a default wave is on the horizon. Here is what you can do: Tactically trade your high yield bond exposure.

Tactical investment strategies are trading strategies, not “buy and hold” strategies. They are systematic mathematical investment processes that seek to identify and profit from price momentum. Price momentum is simply the tendency of a particular stock, index, or other investable asset to persist in its relative price performance.

Below is a weekly chart of the Barclay’s High Yield Bond ETF (“JNK”). The solid blue line is the plotted weekly price movement of JNK. The red line is the 21 week Exponential Moving Average (EMA) of JNK. A buy signal is generated when the weekly price (blue line, green arrows) crosses above the 21 week EMA (red line). A sell signal is generated when the opposite occurs (red arrows).